Covered call writing is the most popular strategy among options traders. In fact, this strategy’s appeal of risk reduction and cash flow are only enhanced when markets are volatile. And with markets seemingly fenced within a wide trading range, covered call strategies such as “overwriting” have become widespread.
Overwriting is a strategy in which long-term clients sell out-of-the-money calls against a portfolio of stocks in which they have sizable embedded capital gains. Typically, such a client has a large stock portfolio and wants to retain the shares but is looking for income.
In that sense, the overwriter differs from typical covered call writers, the latter of whom generally target a strike price at which they would be willing to sell their shares. For the overwriter, the trick is to avoid the tax consequences of an assignment notice.
And there’s the crux: when selling covered calls — no matter how far out of the money — there is always the risk of an assignment. As such, the overwriter must be prepared to engage in followup strategies that minimize taxes.
For example, let’s assume that your client holds 500 shares of Apple Inc. (symbol: AAPL; recent price: US$402.50) at a cost base of US$150 a share — the level at which Apple was trading in the summer of 2009, by the way.
Now, let’s assume that when the stock was at $350 a share, your client sold five AAPL December 400 calls at US$10 a share. You were not expecting your client to be assigned, but here we are in the middle of iPhone 4S mania. Assignment looms.
The short call is trading at US$20 a share — and unless you do something soon, assignment is likely. As a result, concerns about selling stock with a US$150 cost base in December have made the taxman the focus of Christmas rather than Santa Claus.
For your overwriter client, followup action needs to be taken before the options expire. One approach is for your client simply to buy back the five calls at a loss. However, that strategy may not be possible if your client is asset-rich but cash-poor.
In such cases, you could look at selling enough shares for your client to cover the cost of buying back the short calls.
In this particular example, the cost to buy back the five short calls is US$10,000 (five calls x 100 shares per contract x US$20 a share = US$10,000), which could be raised by selling 25 shares of AAPL.
With the buyback, your client keeps the gains on the majority of the shares (500 shares minus 25 shares = 475 shares remaining); and, having removed the short calls, your client is free to sell another call at a higher strike price with a lower probability of being assigned.
The tax consequences of such a move are minimal, as your client has a US$5,000 capital loss on the short call repurchase that offsets a capital gain of US$6,312.50 on the sale of 25 AAPL shares at US$402.50.
In short, your overwriter client has avoided substantial tax consequences, maintained the bulk of the stock holdings, participated in upside appreciation and now has the opportunity to sell more call options on the remaining 475 shares.
Generally, you would expect about 20% of the shares in an overwriter’s portfolio to be called away during any given year. The bulk of the portfolio remains intact while your client enjoys an enhanced income stream.
This strategy also lowers the risk in the portfolio and should provide a more streamlined performance track.
Specifically, overwriting works best in a trading-range environment in which premiums are trading at above-average implied volatilities. IE